Making sense of the markets

27th January 2012

The investment map is changing, and categorising sectors and markets into ‘risky' and ‘safe' is a fool's game when nobody knows what's around the corner. So deciding where to put your capital, and the level of investment risk you're happy to take on has never been trickier.

Top help, why not put risk to one side, and opt for simple, sense-making tools to pick your way through the market maze for long-term gains. Otherwise, it's too easy to make errors by attempting to predict the market.

John Authers, author and previous Financial Times' investment editor, warns in The Fearful Rise of Markets:"Synchronised markets warp perception and force politicians and investors alike into historic errors – but eventually collapse under their own contradictions. In 2008, investors bet simultaneously on a banking collapse and an oil spike and caused an inflation scare in the middle of a credit crisis. When it ended, oil, foreign exchange, and stock markets all reversed, setting the scene for collapse."

He adds in summary: "Markets are reflexive – they can create their own reality."

Common sense investment rules for the long-term

"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."

The Reformed Broker says on his blog: "Pay no attention to people who are always pessimistic. The dirty secret is that even when things are terrible, they aren't that bad. 2008 was the worst sell-off and economic conundrum in 70 years and it only took 18 months for the market to come all the way back. If you fell asleep in 2007 and woke up now five years later, your diversified portfolio including dividend income and unrealized gains/losses looks like nothing ever happened at all.

Equally, he says: "Pay no attention to people who are always optimistic. They are selling something. If someone can't admit that things suck every once in a while, their cheerfulness has an ulterior motive. Or they belong in an insane asylum."

Earnings growth is the best friend of any long-term investor

Buy large and mega-sized stocks that you believe will see earnings growth, pay consistent dividends and have low debt-to-equity ratios. The maths is simple. If a company grows 10% a year, earnings will double in around seven years. If a company grows 15% a year, earnings will double in five years.

Feast or famine

As the Psi-Fi blog notes, key "evolutionary adaptations designed to aid our survival in prehistory are dangerous in modern life".

For example, our hunter-gatherer ancestors would have wondered where their next meal would come from. Hunting for food took effort, not to mention risk. So eating more than our fill when the rare opportunity presented itself made sense, says Money Week. The modern Western consumer, on the other hand, has no need to fear hunger. Food is easily attainable: "the risk side of the risk-reward equation" has been turned off, as it were. Yet we still "eat as much as is put in front of us", regardless of how full we are.

The same instinct can be seen at work in stock markets when bubbles form. Once euphoria takes hold, whether in technology stocks, housing, or precious metals, "people forget about risk, because everyone else does, and gorge themselves stupid". Investors chase already expensive stocks higher, making the eventual fall-out from the bust worse when it arrives.

Invest in what you're interested in

The financial media wants you to think you are missing out on something and that you need to tune in or click to get up to speed, says the Reformed Broker. "Pay attention only if you are generally interested and get some entertainment value out of it, most of the time the headlines and segments are dreamed up by editors and producers who need something interesting to talk about each day. And that's fine, everybody has to earn a living – but don't think anyone is keeping you informed as a public service."

Importantly, it's wise to invest in a business you're truly interested in – and understand. Warren Buffett calls this the "circle of competence."

Look around you. You can always spot investment opportunities by concentrating on what you already know and are familiar with. Some examples would be the industry you work in. Supermarkets, say, that you shop in, or a particular fashion brand you think is on the up.

Don't follow gurus

Avoid falling victim to those seminars that promise to make you a millionaire. It's fine to read books written by successful investors and businessmen that you admire – but don't take their word as gospel.

History shows that the market always goes up given enough time. So the key for investors is to hold their nerve – Keep Calm and Carry On.